By John M. Jascob, J.D., LL.M.
Responding to a request for comments under the FINRA360 initiative, NASAA offered the views of state securities regulators on FINRA’s funding portal rules and rules concerning direct participation programs. NASAA also commented on FINRA’s proposed amendments to Rule 5110 governing underwriting compensation.
Funding portal rules. NASAA commended FINRA for finalizing its Funding Portal Rules, which took effect on January 29, 2016. NASAA urged FINRA to closely monitor the portals to ensure that they are operating according to regulatory requirements. In NASAA’s view, FINRA should require funding portals to conduct due diligence to determine if crowdfunding issuers are in compliance with SEC rules and remove any offerings that do not comply with those rules.
If funding portals are providing additional services that are unnecessary or provided at unreasonably high prices, NASAA believes that FINRA should address this issue through rulemaking or enforcement. NASAA also encouraged FINRA to provide greater guidance regarding the forms of compensation, such as options and warrants, which a funding portal can receive from listed issuers. Finally, NASAA urged FINRA to work with the SEC and state regulators to address potential issues that may prohibit certain funding portals or intermediaries from effectively participating in intrastate crowdfunding offerings.
Direct participation programs. With regard to direct participation programs, NASAA encouraged FINRA to address complex deferred compensation arrangements that have now become commonplace following FINRA Regulatory Notice 15-02, which discussed rule amendments requiring members to provide more accurate per share estimated values on customer account statements. NASAA believes that FINRA should reevaluate the net investment methodology under 15-02 and consider revisions to avoid certain broker compensation being disclosed as an expense. NASAA noted that offering circulars have disclosed deferred broker-dealer compensation as “ongoing shareholder servicing” or “distribution fees.” In NASAA’s view, this fee should be referred to as a deferred commission and should be fully deducted from the value attributed to the account statement.
NASAA also urged FINRA to continue to watch valuations closely, and require additional due diligence from member firms that use valuations of valuation firms on customer account statements. FINRA should also evaluate the advertising review for these offerings, perhaps disclosing risks on the same line as the advertising content, NASAA wrote.
Corporation Financing Rule. NASAA also offered comments on proposed amendments to Rule 5110, which requires FINRA members who participate in an offering in which they are providing services to the issuer to file certain information with FINRA for approval prior to the offering taking place. NASAA supported FINRA's proposal to change the lock-up period for securities considered to be underwriting compensation to 180 days following the date of commencement of sales of securities, rather than from the date of effectiveness. NASAA believes this change will provide increased protection for investors, as the first sale may not occur until long after the date of effectiveness.
NASAA noted, however, that NASAA's Promotional Shares Statement of Policy requires a lock-in period of at least one to two years in order to ensure that investors and promoters assume similar risks in the offering. Accordingly, NASAA urged FINRA to consider requiring a longer lock-in period under Rule 5110 in order to more closely align the interests of the underwriters with those of the investors in the offering.
Underwriting compensation. NASAA questioned provisions in the proposal that would allow the total dollar amount of underwriting compensation to be presented as a maximum aggregate amount in the prospectus rather than itemized for each type of compensation. Rather, NASAA supported the preservation of the existing required itemized underwriter compensation disclosure, which allows investors to understand how money is being disbursed to underwriters. NASAA believes that this disclosure provides investors with a better understanding of incentives underlying an underwritten public offering, and provides investors additional liability protection for any misstatements in the disclosure.
Valuation of underwriter's options and warrants. Among its other comments, NASAA questioned the rationale for eliminating the current formula for the valuation of options, warrants, and convertible securities that have an exercise or conversion price. While the FINRA proposal would allow underwriters to value these securities based on a securities valuation method that is commercially available and appropriate for the type of security, NASAA believes that the current valuation formula serves a useful purpose by providing an objective valuation method that provides consistency across different offerings.
NASAA also urged FINRA to reexamine whether it is appropriate for an issuer to grant any options or warrants to underwriters , noting that potential conflicts could impact the due diligence process. Also, once the firm that participated in the underwriting holds company options, it could potentially skew the recommendations that the broker-dealer then makes to its customers. NASAA also asked FINRA to consider banning all sales contests and similar sales incentive non-cash compensation arrangements, stating that these promotions create almost insurmountable conflicts of interest.